Vertical call option spreads: Defined risk and reward with a bearish bias

If you’re already familiar with selling put vertical spreads for a credit as a neutral-to-bullish strategy, but you happen to be in a bit of a bearish mood, don’t worry. There’s a defined risk/defined reward strategy for that, too.

It’s called the short call vertical spread, and it could be your go-to strategy for when you have a downward bias in the market (or in a particular stock), you like taking in premium up front, and you don’t want open-ended risk in the event of a massive rally.

Selling vertical spreads: A refresher

The term “short vertical spread” can be a mouthful, but it simply means you’re selling a put or call option for a credit and simultaneously purchasing a long put or call option of the same expiration date, but further out of the money. So with a short vertical spread, you’ll:

• Take in more premium on the short leg than you’ll pay in the long leg—that is, you’ll collect a net credit, which represents the maximum profit on the trade.
• No longer have open-ended risk, because if both options finish in the money, both will be exercised, and you’ll have no net position in the underlying asset.

For the following examples of vertical spreads, consider a stock that’s trading at $102 per share, with the following strikes and prices for an option series that’s expiring in 40 days.

Expecting a pullback? Try a short call vertical spread (bear call spread)

Suppose the stock has had a sizable rally and you think it’s poised to either sit still for a while or perhaps pull back a bit. You might consider short-selling a few shares of the stock, but that can be complex, risky, and—depending on the permissions in your brokerage account—you might not be allowed to. If you’re an options trader, you could sell an uncovered (“naked”) call option and collect the premium. But that’s also quite risky. Short-selling and naked short calls can leave you exposed to unlimited upside risk if the stock continues to rally.

An ideal solution may be to sell an out-of-the-money (meaning strike prices are above where the market is currently trading) call vertical spread. It’s also called a bear call spread, or in options trader lingo, a “short call vertical.”

You might choose to sell a 110-strike call at $3.05 and buy a 115-strike put at $1.72 (“short the 110/115 call vertical”) for a total credit of ($3.05 – $1.72) = $1.33.Because each option contract controls 100 shares of the underlying stock, your initial credit would be $133.

Note: Most brokers’ trading platforms will allow you to enter the spread in a single order ticket.

Breaking down the short call vertical trade

• The bear call spread is neutral to bearish. If the stock stays below $110, you’ll keep the $133. In other words, your max profit is $133.
• Your max loss is $367. If the stock rises above $115 at or before expiration, you’ll be assigned a short position in the stock at $110, but you’ll exercise your right to buy at $115. That locks in a loss of $500 minus the $133 premium you took in, or $367.
• What if the stock closes between the strikes as expiration approaches? Now you’ll have a couple of choices. Because the short strike is in the money, you have the risk of being assigned a short position in the shares. If this is something you don’t want to happen, your best course of action is to close the spread before expiration. Even if the stock is above the strike you sold, the trade may still be profitable based on the amount of credit you collected.

What are the potential outcomes?

Vertical spreads are a flexible way to customize your ultimate risk and reward. One of the attractive features of selling out-of-the-money put or call vertical spreads is that the probability of profit is high. In other words, the odds are in your favor. Don’t get too excited, though—the risk/reward metrics are often unattractive for this type of spread. This is the trade-off between probability of profit and risk.

Once executed, there are five possible outcomes for the put vertical:

1. The stock can go down. You’ll pocket the premium.
2. The stock can stay flat. Also a pocket-the-premium scenario.
3. The stock can rise a little, but stay below your short strike. Yet another pocket-the-premium scenario.
4. The stock can land somewhere between your strikes. There’s opportunity for a potential win even above your short strike, as long as the stock doesn’t rise above your credit breakeven (i.e., the initial premium you took in).
5. The stock can rise a lot, all the way through your short strike and long strike. You’ll incur the maximum loss, regardless of how high it goes.

Among those five possible outcomes, you can win in three or four. Pretty good percentage, right? The trouble is—and it’s something you’ll see time and time again with options—the risk/reward is typically commensurate with the underlying probabilities. In other words, the more likely an option is to be profitable, the lower its payoff relative to the amount you could lose.

In this example, the odds of a profit are pretty favorable. But the most you could lose with this spread, $367, is more than twice your max profit of $133. And if you employ this strategy regularly, say each month, each time one of your spreads hits the max loss, it will erase the gains on several of your previous winning vertical spreads.

That’s why risk management is a key consideration.

Breakeven and expiration

The math on calculating the breakeven on a short vertical call spread is fairly straightforward. Simply take the value of the short strike sold and add the credit you collected. Using our example:

• Short strike sold on a 5-point short put vertical: Sell the $110 call and the $115 call.
• Credit received: $1.33
• Breakeven: $111.33
• Max risk: $3.67 (5-point vertical width, less the credit received of $1.33)

Now that you know your breakeven and max risk, you may ask whether it’s necessary to hold the credit spread all the way until expiration. The short answer is no. You can close out a position at any time. Veteran options traders know this and use it to their advantage.

With our short call vertical example, if the underlying stock were to fall fairly quickly, you might only need to be in the trade for a few days to realize a profit on the majority of the credit you collected. In that case, it may make sense to just close the trade down early at the current profit level and deploy your capital elsewhere.

With the credit working in your favor, many traders adhere to a rule of closing the trade once a certain percentage of the original credit collected has been realized as profit, say, 50% or 90%. This is really up to your discretion as a trader and how it fits in with your risk management rules.

The bottom line

Short vertical spreads are a popular defined-risk and defined-profit strategy. If your directional bias is to the downside, selling a call vertical might be your go-to strategy choice. If you keep to out-of-the-money strikes, the odds of finishing with a profitable trade are on your side, but as noted above, the maximum loss is much greater than the maximum profit.

One way to control the risk is active management. If you know your profit and loss targets, you can time your entry and exit to your maximum relative advantage.

The ability to pick your time frame and the strike prices that define your spread makes short vertical spreads a flexible strategy that you can match to your account size, time frames, and risk tolerance. But if you’re just starting out, start small and keep your risks well-defined and under close watch.